This article was originally published on May 20, 2015. It was updated on May 5, 2016.
If you're confused by tax forms and get your 1099s mixed up with your W2, read on. But when it comes to the 1099 vs W2, there's an issue greater than just tax-form identification: The two forms represent two different kinds of worker classification, with business implications and sometimes even ethical ones, too.
In a nutshell
First, though, let's simply review the forms. Most of us have probably seen a W2 before. It's what an employer sends its employees each year, summarizing wages paid and taxes withheld, and it's a necessary document when it comes time to preparing your tax return.
The 1099 form, meanwhile, also reports income you have received in the past year, but it's a bit different. It comes in many varieties, reflecting, for example, income earned as a contractor or freelancer (via the 1099-MISC), dividends (1099-DIV), and interest (1099-INT).
Many people actually receive both forms if they work as salaried employees but also collect other forms of income during the year. Most of us, though, will see the vast majority of our income reported on either a W2 form or a 1099 form -- because we are an employee, a freelancer, or a contractor.
1099 vs W2: the employee perspective
Many of us get to choose how we want to work, whether as an employee, a contractor, or a freelancer. If you're thinking about leaving the salaried life for a little more independence and flexibility, or vice versa, here are some factors to consider.
Taxes: The self-employed pay twice as much Social Security and Medicare (FICA) taxes, because employers normally pay half. Self-employed folks will typically pay all 15.3% -- a significant portion of their income. (That's 12.4% for Social Security and 2.9% for Medicare.) On the other hand, work-related expenses such as postage, travel, Internet access, and home-office maintenance can be deducted on your tax return. Taxes are more complicated for self-employed people, as they often have to make quarterly estimated tax payments throughout the year.
Insurance: Many employees get access to discounted health insurance, often along with life insurance, disability insurance, and other benefits. Self-employed people have to pay for their own -- though health insurance premiums can be deductible.
Work expenses: As an employee, you're provided with the office essentials, such as a desk, a computer, etc. If you're self-employed, then you must provide them yourself.
Retirement: Many employers help their workers save for retirement by providing 401(k) plans or similar plans, often offering matching funds. Freelancers and contractors get none of this and must save on their own. There are several tax-advantaged accounts that can help with that, such as SEP IRAs and SIMPLE IRAs.
1099 vs W2: The employer perspective
From an employer's perspective, it's often preferable to hire freelancers and contractors instead of employees. For one thing, they won't have to pay for all the benefits they would offer employees, such as health insurance and perhaps life insurance, not to mention bonuses, stock options, 401(k) plan contributions, and so on. It can also be much easier to terminate a relationship with a contractor or freelancer than with an employee, and contracts can be tweaked or changed from one period to another, suiting employer needs.
The issue has increasingly been in the news, as many companies are increasing their proportion of contractors in order to spend less on staffing. Employers generally make these choices well within the law, but some have been accused of classifying workers who should be considered employees as contractors instead.
The IRS has issued guidelines on the matter, saying, "If you have the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees." Meanwhile, "If you can direct or control only the result of the work done -- and not the means and methods of accomplishing the result -- then your workers are probably independent contractors." The distinction is important because there are penalties for misclassification.
Still, there's a good case to be made for favoring employees over contractors. Employees can feel more secure in salaried jobs, and they might be more apt to focus on the job at hand instead of lining up other jobs. Valuable benefits and perks can help retain talented employees, enhancing productivity and minimizing the cost of recruiting and training new people.
Whether you're an employer or a worker, it's worth giving some thought to 1099 vs W2 forms and the distinction between employees and contractors.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.